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Q

Is life insurance taxable?

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A

The life insurance death benefit is not usually taxable, but there are exceptions.

Colin Lalley 1600Amanda Shih author photo

Colin Lalley & Amanda Shih

Published August 7, 2020

KEY TAKEAWAYS

  • Life insurance death benefits are generally issued tax-free

  • Incremental payouts and employer-provided group life insurance may be taxed

  • If your total assets exceed a certain amount, you might face an estate or inheritance tax

  • Speak to a licensed financial adviser about the tax implications of your life insurance policy

Life insurance is one of the best ways to build a financial safety net. The life insurance death benefit provides money to beneficiaries to pay for things like college, a mortgage, and more.

Most large sums of money, like lottery winnings, are subject to tax. So, are life insurance proceeds taxable? Usually not: Most term life insurance policies pay out a non-taxed sum. But some scenarios, like having permanent life insurance with a cash value or selling your insurance policy do make the death benefit taxable.

IN THIS ARTICLE

When is the life insurance death benefit taxable?

In general, life insurance proceeds are not subject to taxation, according to the Internal Revnue Service (IRS). The money is typically disbursed tax-free to your beneficiary. However, there are some instances when taxes come into play; they include circumstances involving incremental payouts, estate size, cash-value life insurance, selling a policy, and group life insurance.

When you receive an incremental payout

A life insurance death benefit is most often doled out as one lump sum of money. However, you can choose to receive it in incremental payouts, also known as an annuity. This can be helpful if you or your beneficiary might be overwhelmed by a large one-time payout; monthly installments better replicate a lost income stream and can be less complicated to manage while you tend to other end-of-life duties and grieve.

However, if a beneficiary elects to go with an installment plan for the life insurance payout, the total death benefit will accrue interest over the years. The beneficiary won’t be taxed on the benefit, but you may be taxed on the interest gained. This is an important extra cost to keep in mind, and an argument for taking the death benefit as a lump sum.

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When your estate exceeds the estate tax

If the addition of the death benefit causes your assets to exceed the estate tax threshold, your estate may be subject to taxation. You can avoid this with an irrevocable life insurance trust (ILIT), which puts the policy and the disbursement of the death benefit under the trust’s control and excludes it from the value of your estate.

You may also gift a life insurance policy you already have to the ILIT, but if the policy hasn’t been part of the ILIT for more than three years when you die, then the death benefit will still be included in your estate’s valuation.

One key term to know when it comes to ILITs is Crummey powers, which is essentially a way to pass assets to beneficiaries free of the gift or estate tax, making it completely tax-exempt. It may be a more complex system than most people need, but the American Bar Association still considers Crummey powers a "powerful estate planning tool." It's best to seek out the advice of a financial adviser, who can help implement it if necessary.

When you have a cash value life insurance policy

Term life insurance policies are straightforward in that the policy guarantees your beneficiaries a death benefit, and nothing more. But permanent policies like whole life insurance come with an investment-like cash-value component, which can complicate your tax situation.

Cash value policies can pay out dividends. These are called participating policies. In contrast, non-participating policies do not pay out dividends (term life insurance is an example of this; there are, less commonly, non-participating whole life insurance policies). Dividend payments are not taxable, as stated in the U.S. tax code.

The cash value of a policy can increase over the years (or decrease), but usually a whole life insurer offers a guaranteed minimum interest. Cash value gains are tax-deferred, much like the gains in a 401k. Withdrawals less than or equal to what you’ve paid into the policy, known as the cash basis, are not taxable. However, withdrawals greater than the cash basis are taxable.

Additionally, you can borrow against your policy’s cash value, essentially taking out a loan. Any unpaid loans (for example, if your policy lapses) are taxable.

Whole life policyholders can also surrender a policy for a cash amount. If you make a profit from the surrender, it’s subject to taxation.

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When you have group life insurance

Some employers offer group life insurance as a workplace benefit. This usually isn’t a substitute for an individual policy because the coverage isn’t very high. The coverage amount also plays a role in taxation.

If you get life insurance coverage through your work and your employer is subsidizing the cost, any coverage over $50,000 is treated as income and if you pass away, the death benefit will be taxed accordingly. This is especially important to keep in mind if you have voluntary supplemental life insurance through your employer, which could place you above that $50,000 limit.

When you sell a life insurance policy

It’s possible to sell the rights of a life insurance policy to a third party, usually a broker or life settlement company. Similar to surrendering a cash value policy, if you sell a policy and make any profit from the sale, that profit is taxed as earned income.

Is return of premium life insurance taxable?

Return of premium life insurance policies do just what they say: When the policy is up, the premiums paid over the previous decades are returned to you.

But a return of premium is tax-free. That’s because the money is literally just a refund and not a payment. You’re refunded the premiums that you paid over the previous 10, 20, or 30 years, minus any potential fees.

That’s both a pro and a con of return of premium life insurance. You don’t have to pay taxes on the money returned, but you’ve also been paying much more than you would for a traditional policy — usually about 30% more than a comparable standard term policy. Plus, you will have missed out on decades’ worth of interest by not investing that 30% difference instead. Investing an extra $50 a month over 30 years, with compounding interest, adds up.

Still not sure if your policy could be taxed? Take a look at this flowchart and see where you fall. Pg Is my insurance taxable-v1 (1)

Life insurance and the tax code

Whether your life insurance is taxable is determined by specific sections of the U.S. tax code. Together, these codes create guidelines for which policy items fall under life insurance tax rules and which don’t.

Types of taxes that can make life insurance taxable

Because a life insurance death benefit isn’t considered taxable income for most people, income tax usually doesn’t apply. However, you or your beneficiary might be subject to estate taxes, inheritance taxes, gift taxes, or the generation-skipping transfer tax.

  • Estate tax — The federal estate tax applies to high-value estates. As of 2020, the federal estate tax threshold is $11.58 million, up from $11.4 million in 2019. Any amount of your estate over the estate tax threshold is subject to taxation.

  • Generation-skipping transfer tax — As the name implies, this applies to assets that skip a generation (for instance, a grandparent leaving property to a grandchild). It has the same exemption limits as the estate tax.

  • Inheritance tax — A tax levied on inherited money, property, investments, or other assets. It is only collected by six states and can range from 15-20%.

  • Gift tax — A federal tax on assets given as gifts. The gift tax is in place to prevent people from avoiding taxes by “gifting” money rather than it being included in an estate. This usually comes into play when the policyholder is still alive and transfers a policy to a beneficiary. There is a lifetime exemption amount, which is the same as the estate tax limit, as well as an annual exemption amount ($15,000 as of 2020).

Remember that some states also apply their own tax laws to some of these scenarios. For example, eleven states and the District of Columbia also have their own estate tax laws, and others have their own inheritance tax laws. Be sure to check the guidelines and limits for your state. These taxes will not apply in every situation, and most people are exempt from them due to their high limits. But they’re important to keep in mind as you put together a comprehensive estate plan.

Tax code sections to know

It’s helpful to know when the tax code might apply to your life insurance, but it’s not vital to know the ins and outs of the entire U.S. tax code. A financial adviser can help you navigate the details and determine exactly what is and isn’t taxable in your situation.

The bottom line

Generally, life insurance is not taxable — your beneficiaries receive the entire death benefit. However, some circumstances could put the death benefit at risk of taxation. When you pass away, it’s not you who will bear responsibility for taxes on your death benefit, but your loved ones.

Make sure to discuss your policy and any tax implications with your beneficiaries ahead of time, especially if you have a policy with a cash value or you think you may be subject to the estate tax, so that there are no surprises. Since every financial situation is different, consider speaking to a financial adviser about your estate plans to ensure your beneficiaries are not saddled with any undue burdens.

About the authors

Insurance Expert

Colin Lalley

Insurance Expert

Colin Lalley is the Associate Director of SEO Content at Policygenius in New York City. His writing on insurance and personal finance has appeared on Betterment, Inc, Credit Sesame, and the Council for Disability Awareness. Colin has a degree in English from the University of North Carolina at Chapel Hill.

Insurance Expert

Amanda Shih

Insurance Expert

Amanda Shih is an insurance editor at Policygenius in New York City. Previously, she worked in nonfiction book publishing and freelance content marketing. Amanda has a B.A. in literature and communication from New York University.

Policygenius’ editorial content is not written by an insurance agent. It’s intended for informational purposes and should not be considered legal or financial advice. Consult a professional to learn what financial products are right for you.

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